 Crypto is incredibly volatile when everyone is trying to reach for the moon There will always be turbulence along the way, but a few crypto currencies aim to do the exact opposite They try to keep their prices steady and solid the earth the cryptos move these are called stable coins wait That's actually a brilliant idea for a project make a stable coin token pair Where the stable coin is named after the earth and the token is named after the moon But as Luna goes into free fall below a dollar. Oh, it fell below a dollar today Absolutely wild Tara halting their network for a second time Luna and UST face extinction. Oh shit Yeah, we'll explain why that happened a bit later in the video because that involved a special type of stable coin called an Algorithmic stable coin before we get into that we need to first understand what a stable coin actually is I'm Jackson Dumont director of video at coin telegraph in this video We'll explain how stable coins work and why they're one of the most crucial parts of crypto If you haven't done so already, please consider leaving a like and clicking that subscribe button We are the leading media for news coverage and education Let's start with a simple definition a stable coin is a cryptocurrency whose value is tied to an outside asset Such as the US dollar or gold This tie is called a peg and it stabilizes the price for example The company tether issues a US dollar peg stable coin called USDT at a one-to-one ratio to the US dollar one USDT equals one USD That means if tether wants them in 10 billion USD tokens They need to have 10 billion dollars in reserve. They can't just mint money out of thin air That right is reserved for the US government This collateral keeps the one-to-one peg because it ensures people are able to redeem their USDT tokens for actual US dollars at any time Despite this maintaining the peg can sometimes be difficult, but more on that later So you might be thinking that stable coins just sound like copies of other assets and you're right That's exactly what they are but with one key difference. Get ready for it. Here it comes They're on the blockchain Never gets old But even though I've said this in a lot of videos the distinction is pretty important because it gives the underlying assets some unique properties minimal volatility as We are all well aware the crypto space is incredibly volatile Cryptocurrencies can pump 10x or just as easily lose all their value overnight in this world of chaos There needs to be a stable benchmark where investors can keep their money safe from risky price action Let's say crypto enters a bear market where every coin is crashing Kind of like what happened in the first half of 2022 There needs to be a place in the ecosystem or on chain where investors can hold tokens that don't lose value Exiting the crypto ecosystem into real-world assets for every trade will be far too costly and time consuming So it only makes sense that most trading pairs are against US dollar peg stable coins like USDT Because the US dollar is the global reserve currency If the crypto market is a machine then the US dollar peg stable coins are the grease that keep it running They are the benchmark against which most other cryptocurrencies are measured without them the crypto market would collapse be your own bank This brings us to the next unique feature of stable coins You don't need a bank to hold them or transfer them. This opens up a world of opportunities Imagine you live in Venezuela where the recorded inflation rate at the start of 2022 was 1198% that means that the official currency of Venezuela the boulevard is losing value faster than any other currency in the world The absolute last thing you want to be doing is holding that currency But maybe your local bank doesn't let you open an account for any currency other than boulevards or maybe you don't even have a local bank What can you do? Well, you can go online to a crypto exchange and buy a USD euro or even gold back stable coin Now your money is sitting in a far more stable currency This will help you fight inflation and not lose the purchasing power of your money low fees no border But maybe that's not enough you need some extra money from your cousin who moved to Canada and you need it fast You don't have time to deal with slow wire transfers and exorbitant exchange fees Instead your cousin can send you a stable coin directly to your own wallet not a banks within minutes for a very small fee Easy peasy problem solve now You can see just how powerful tool stable coins can be and this is only because these crypto currencies exist on global Decentralized networks that are not controlled by governments banks Corporations or any other centralized entities the hardest part is helping people understand how to use it So now that we know what stable coins are good for how do they actually work? Well, we can break things down by dividing stable coins into four different categories Fiat backed commodity backed crypto backed an algorithmic Fiat backed stable coins work exactly as we explained a bit earlier in the USDT example Fiat collateral must always be in a one-to-one proportion to the number of tokens issued The collateral is held in reserve by a central issuer or financial institution Regulators require these issuers to frequently disclose the reserves to make sure they always have enough backing for the tokens They meant commodity backed stable coins work in a similar fashion these stable coins are Collateralized with physical assets like precious metals oils and real estate rather than with currencies the stable coins price reflects the value of its underlying asset For example each token of Paxos gold Pax g represents one ounce of gold However, because the prices of these stable coins are tied to commodities They are more volatile than their fiat pegged brethren two of the most popular commodity backed stable coins are tether gold and Paxos gold Holders of these stable coins can sell them for cash or the underlying gold This facilitates investments in assets that may otherwise be out of reach locally However, both fiat backed and commodity backed stable coins require a central issuer to provide collateral for each token In the world of cryptocurrency, we seek to decentralize as much as possible Crypto backed stable coins seek to do just that by using smart contracts instead of relying on central issuers If you're not sure what smart contracts are check out our video here as the name suggests Crypto backed stable coins use other cryptocurrencies as collateral when you purchase these stable coins You lock your crypto in a smart contract and the smart contract gives you tokens of equal representative value This is called a collateralized debt position. The prominent stable coin in this category is die Usually these kinds of crypto backed stable coins require over collateralized positions Essentially, you have to put more crypto into the smart contract than you are taking out This is to protect you against price fluctuations, which could cause liquidation However, sometimes even over collateralization doesn't save users from liquidation during extremely volatile market conditions The final category of stable coins are algorithmic stable coins These are the newest types of stable coins to emerge and they are still finding their footing to put it lightly Contrary to previous categories algorithmic stable coins do not use fiat or crypto as collateral Instead, they use a complex system of algorithms and smart contracts to manage the supply of tokens and circulation thereby Controlling the price when the price of the stable coin deviates below its peg Tokens are burned from the circulating supply pushing the price back up Conversely, when the price of the stable coin goes above the peg tokens are minted into the circulating supply pulling the price back down Terra was a great example of this. It combined a governance token called Luna with a suite of fiat peg stable coins such as UST Terra incentivized its users to take advantage of small differences in price of the same asset across different marketplaces Essentially if UST was valued at one dollar and one cent instead of one dollar Users could burn one dollar worth of Luna to mint one dollar and one cent worth of UST Investors could then sell the UST for one dollar and one cent earning a profit of one cent for their efforts Burning Luna tokens reduced the number of overall tokens left in circulation Making them more scarce and therefore more valuable by minting more UST tokens it had the effect of Diluting the existing tokens and circulation and bringing the overall price back down to its one dollar level Ideally users would keep this process going until the UST value decreased back to one dollar The opposite would occur if UST fell below one dollar Think of it like a seesaw Constantly trying to balance itself. The problem is that this system failed big time. It crashed the whole market What happened was this a lack of demand for UST drove the price below its one dollar peg Traders saw this opportunity and began burning UST for one dollar worth of Luna which was then sold for a profit So far everything was working as intended However, the continued selling of Luna led to its price plummeting not only canceling out the arbitrage opportunity But increasing the amount of Luna in circulation while the price continued to crash Investors saw the system crashing and immediately tried to sell their holdings which only caused the prices to crash even faster When the dust settled Luna and UST had lost a mind-boggling 100% of their value in just a few days costing investors billions of dollars This event was a sobering reminder that even experiments aimed at stability can have devastating consequences But it also goes to show just how key stablecoins are in the crypto ecosystem They are faster than banks transcend borders and oil the crypto machine Imagine if an even larger stablecoin like USDT or USDC suddenly collapsed a black swan event like that would make the UST fiasco look like a walk in the park and remember those stablecoins are issued by centralized Corporations they look safe for now, but they still have a single point of failure and are at the mercy of the regulators Who knows what can happen the need for a decentralized stablecoin hasn't gone away and although Luna failed that Failure will pave the way for better smarter stablecoin systems when that happens coin telegraph will be here to cover it I'm Jackson Dumont. If you enjoyed this video, please leave a comment below and what you'd like to see me cover next